John Kelly: Commercial property makes a return

With returns expected to reach double figures, CCLA’s John Kelly writes that commercial property is increasing its attraction to investors

2014 proved to be the year when commercial property finally and dramatically put behind it the legacy of the recession and the financial crisis which followed it. Capital returns were strong and comfortably above the forecasts made at the start of the year, driven higher by strong fund inflows from both UK and international investors keen to participate in the recovery and, in an environment of persistent low interest rates, to lock-in the attractive yields available.

For the year ahead we expect this flow of new money to continue, compressing yields further and pushing valuations higher again. Investor focus however is expected to broaden as sentiment improves, away from a concentration on the defensive assets which gave the best returns in the downturn, to others areas more geared to recovery. The fact is that past demand has pulled the yields on trophy assets in London down to levels which are now only fair value.

In contrast, there are excellent properties away from the capital where valuations are still a long way below the levels reached before the downturn and yields, protected by the contractual nature of the income, are high.

Looking at the opportunities available two broad areas look particularly attractive; industrials, where underinvestment in new capacity over an extended period has created shortages which are already being reflected in rising prices and improving rents across the UK. The other is regional offices, particularly in the south east. This is a sector which fell substantially out of favour with investors in the recession, pushing yields up to levels justifiable only in very difficult conditions.

In fact the environment is improving with underlying demand higher and excess capacity being converted to alternative use, including residential. We need to recognise of course that, although the overall trends are encouraging, it is not true that all parts of the sector are similarly attractive. Retail is the area currently with most issues as powerful factors such as demographics and technology influence how we shop.

A feature of this economic recovery has been the strength of consumer expenditure and yet is noticeable how conditions on many high streets are still flat and how few of the major chains are planning to expand. Within the retail sector supermarkets are another concern. This is a sub-sector which is currently highly rated by investors as a long-term provider of secure income but this status is being challenged by a change in shopping patterns which is creating a potential oversupply of large out-of – town sites on a significant scale. This is potentially a serious development which could have a substantial and negative effect on valuations for some time.

Returns in 2014 were dominated by capital gains; this year should be more balanced with an important contribution from rental growth. Historically rents have been closely linked to economic activity, coming under pressure as the cycle turns down and then rising once more when the upturn becomes established. With the recovery now well established rents have stabilised and the incentives such as rent free periods are reducing in most parts of the sector. Given the nature of the current upturn it is not surprising that rental growth is strongest in London, but there are clear signs of improvement elsewhere, signs we expect to broaden and strengthen over the months ahead.

What does this mean for investors? The short answer is that they should enjoy another year of strongly positive returns. Capital growth will not be as strong over the next 12 months as it was over the last, but it should still make a useful contribution to performance. Income is likely to grow, establishing a trend which historically has extended for a few years. Property is already the highest yielding of the major asset classes and a rising must increase the attraction to investors. Projecting returns is always a high risk undertaking but at this stage of the year our expectation is for total returns approaching double figures.

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